Market Outlook: Stock Market Is Bouncing After Being Extremely Oversold

In other words, a retest is more likely than no-retest. As I said last week:

After such crashes, the stock market typically makes a quick bounce, a retest, and then a medium term rally. What follows the medium term rally depends on macro (the economy).

  1. If the economy continues to improve, then the stock market will push on to new highs, even if the rally is very choppy. (This was the case in 1987-1988 and 1998-1999. Macro improved after the crash, pushing the stock market higher).
  2. If the economy deteriorates, then the stock market will go on to make new lows.

We are watching macro carefully in 2019 through our Macro Index.

Let’s get into the quantitative market studies.

*For reference, here’s the random probability of the U.S. stock market going up on any given day, week, or month.

We rank our market studies in order of importance.

  1. The stock market’s own fundamentals and technicals (primary importance)
  2. Correlation and specific sectors (secondary importance)
  3. Seasonality, short term factors (tertiary importance)

The stock market’s own fundamentals and technicals (primary importance)

Wall Street conventional “wisdom” states that “big rallies only happen in bear markets”. This is partially true, but only when these big daily rallies occur AFTER the stock market has fallen -30%, -40%, or -50%

Big rallies also happen in -15% to -20% declines that are followed by new all-time highs.

The S&P has rallied more than 3.4% in 2 of the past 10 days, while within 20% of a 2 year high. 

Here are similar cases, from 1950 – present

Even in the bear market cases (2008), the stock market made a 2 month rally.

Here’s the same chart, but including data from 1929 – present

You can see that this was clearly not bullish in the Great Depression. But context matters. Comparing today to 1933 (at the bottom of the Great Depression) is silly. Leave that to the world-is-ending people.

Technical traders often look for “breadth thrusts” to confirm bottoms. Over the past 2 weeks, there have been 2 days in which more than 90% of issues on the NYSE went up.

Here’s what happened next to the S&P 500 when it fell to a 1 year low, and then witnessed 2 breadth thrusts in 2 weeks.

*Idea from member Bret Zimmerman

This is pretty consistently bullish for the stock market, especially 6+ months later.

While stocks have performed poorly in 2018, investors allocation to equities has fallen. The following chart demonstrates AAII’s Ratio ot Equities allocation to Cash allocation.

There is only one such decline in Equities allocation that is similar to today’s: March 1999.

In that historical case, the bull market continued for another year (everyone thought the 1998 -20% decline was the start of a much bigger bear market). Towards the end of a bull market, you just don’t know if bull market has 1 more year (blow-off top) or not. “The bull market is dead” is not a foregone conclusion.

Momentum has bounced from extreme oversold levels.

The S&P 500’s 30 daily RSI has gone from under 30 to above 43 (bounce from extreme oversold levels). 

Historically, this can lead to short term weakness in the stock market over the next 1-2 weeks, but after that forward returns were random.

Technical studies can be improved with macro context (which is what we do in the Membership Program). Here’s the same study, but only looking at the cases in which the unemployment rate was under 6% (i.e. late-cycle cases)

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Our discretionary outlook is not a reflection of how we’re trading the markets right now. We trade based on our quantitative ...

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